Toward a Strong Unemployment Insurance System

The Case for an Expanded Federal Role

SOURCE: AP/LM Otero

Job seekers line up for a job fair at a hotel in Dallas on January 26, 2011. We all benefit from an unemployment insurance system that can be an effective automatic stabilizer during recessions, especially prolonged recessions like the one we’re now escaping.

The purpose of the unemployment insurance system, as President Franklin D. Roosevelt noted upon signing the legislation into law, is both to alleviate hardships for the unemployed and to counter recessions. The rules are that to receive unemployment benefits, a worker must have lost their job through no fault of their own and be actively seeking re-employment. In the wake of the Great Recession, the unemployment insurance system has been effective in helping families hardest hit by unemployment. In 2009 alone, unemployment benefits lifted 3.3 million families out of poverty.

The second purpose of the unemployment insurance system affects us all, whether we are unemployed or not. The system is explicitly designed to act as an “automatic stabilizer” for the economy. The unemployment insurance system acts “countercyclically,” pumping money into the economy when unemployment is high by paying benefits that replace lost wages to those involuntarily unemployed while they search for work. This boosts economic growth just when the economy needs it most. Economists estimate that during the Great Recession, unemployment benefits closed about one-fifth of the recession-caused gap in total economic output. These benefits are paid for through federal and state taxes on employers, which are highest when employment is high and thus not inordinately pulling down employment during recessions.

In the wake of the worst recession since the Great Depression, however, our nation’s unemployment insurance system is in a crisis that threatens both its hardship-alleviating and automatic stabilizer functions. Most state unemployment insurance systems are now insolvent due to the lack of adequate payments into the system in the nonrecession years preceding the Great Recession and the subsequent tepid jobs recovery that has required many states to continue to pay benefits for an extended period of time. As a result, most states (32) have taken out loans from the federal government for their unemployment trust funds to the tune of over $42 billion (see Table 1 below).

This issue brief lays out the key elements of a plan to accomplish the goal of shoring up the unemployment insurance system’s role as an effective automatic stabilizer, while addressing the solvency crisis in the states. The first step is to clear the deck by forgiving the trust loans of insolvent states and rewarding states that maintained positive trust-fund balances. We propose a set of conditions for the deck clearing that will improve the core functions of the unemployment insurance system by:

Clearly delineating and separating the federal and state roles by increasing the role of the federal trust fund during times of high unemployment

Reducing the wide disparity in eligibility rules and benefits across states

Our proposal will reduce costs for states as their labor markets struggle to emerge from the Great Recession, improve benefits for the unemployed, and better stabilize our economy in future recessions.

Addressing the trust-fund solvency issue is both urgent and important because if it is left unaddressed, states will see higher taxes long before the labor market has recovered from the Great Recession. Higher taxes will happen through two separate mechanisms. First, federal law requires that states with loan balances see a reduction in their federal unemployment insurance tax (the so-called FUTA tax) credit, which has the effect of increasing taxes on employers in states that have not repaid their trust fund loans quickly enough. Three states—Indiana, Michigan, and South Carolina—currently fall under this rule and are paying higher taxes, and 25 states and the Virgin Islands are projected to experience a reduction in their FUTA credit next year (see Table 1).

Second, while the federal government waived interest accrual and payments on trust-fund loans between February 2009 and December 2010, this waiver has expired. As of October 2011, 32 states will owe an estimated $1.7 billion in interest (see Table 1). Yet the funds used to pay off the interest on the trust fund loans cannot come from the state taxes dedicated to funding the unemployment insurance system, but rather must come from either the states’ general revenues or from other funding sources, and most typically come from charging a surcharge tax on current employers’ payrolls.

How policymakers address the unemployment insurance trust fund insolvency crisis will have significant implications for the effectiveness of the program as an automatic stabilizer in the years to come. To be an effective automatic macroeconomic stabilizer, the unemployment insurance system must replace a reasonable share of unemployed workers’ lost income for a significant share of workers still looking for a job. It must also have the flexibility to extend the number of weeks of benefits available to the unemployed as the unemployment rate rises and job searches become protracted. Any reforms that address insolvency should protect—and improve—these core functions.

Both elements of the automatic stabilizer function are threatened by the debt piling up in most states’ unemployment insurance trust funds. If history is any guide, as states struggle to pay off the debt, they will be under pressure to tighten eligibility rules and/or cut unemployment benefits, both of which limit the countercyclical effectiveness of the unemployment insurance system for our economy moving forward and punish workers who can’t find jobs not for lack of trying. The last time states tightened eligibility criteria occurred after the U.S. economy faced double-digit unemployment in the early 1980s. Similar to what happened during the Great Recession, most states (32) took out federal loans to pay out benefits and the federal government did not provide assistance with the loans. Between 1981 and 1987, as states struggled with repayment, nearly all states (44) enacted more restrictive benefit eligibility standards and as a result, the percent of jobless workers receiving unemployment benefits dropped from 50 percent in 1975 to 31.2 percent in 1988.

The problems facing the unemployment insurance system present Congress and the Obama administration with a unique opportunity not only to respond to the immediate problem of high-unemployment but also to create a stronger and more effective countercyclical unemployment insurance system going forward. The unemployment insurance system would be improved if the roles of the state and federal governments were harmonized so that the states could focus on what they do best—administration and re-employment services—and leave the financing for times when the unemployment rate is elevated to the federal government.

Unemployment insurance should act as an automatic stabilizer

The unemployment insurance system helps those who have lost their job for no fault of their own, but is also of great value to the economy as a whole. By providing benefits to those directly experiencing unemployment, unemployment insurance acts as an automatic stabilizer, filling in the gap in overall consumption left by high unemployment.

Families that receive unemployment insurance benefits typically spend these benefits rather than save them. To put some back of the envelope numbers on this, think of it this way: The typical worker brings home about $40,000 annually and about 15 million people are out of work, so without unemployment benefits, our national income would shrink by about $600 billion. It’s that gap that unemployment insurance fills and why it’s critical to sustaining the economic recovery. And, why we can’t just fill the output gap with tax cuts. In a report for the Department of Labor, Wayne Vroman, economist at the Urban Institute, estimated that the unemployment insurance system closed about one-fifth (18.3 percent) of the shortfall in the nation’s gross domestic product during the Great Recession.

Because unemployment benefits typically get spent immediately, unemployment insurance has what economists term a high “multiplier effect,” because most every dollar that goes out in unemployment benefits is spent immediately, boosting economic growth. Recent data from the Department of Labor shows that for every dollar of unemployment benefits provided during the Great Recession, $2 was added to U.S. gross domestic product, or the total output of goods and services in our economy.

For the unemployment insurance system to be an effective automatic stabilizer, the system must provide benefits with a reasonable wage replacement to those who have lost their jobs through no fault of their own and who continue to seek employment without success. If the eligibility rules are too onerous and too few unemployed workers qualify for benefits, or conversely if benefit levels are too low relative to pre-job loss earnings, this will significantly dampen the overall countercyclical impact of the program.

The unemployment insurance system, however, is not entirely successful at either reasonable wage replacement or covering everyone who is involuntarily unemployed. The Department of Labor reports that the typical worker only has about one-third of their pre-job loss wages covered by their unemployment benefits, although workers may receive more as generally benefits are capped at a 50 percent replacement rate (see Box).

Just as importantly, there are wide differences in benefit levels across states and across workers, which limits the automatic stabilizing impact of unemployment insurance system. For instance, Wayne Vroman of the Urban Institute examines the effect of the wide differences in unemployment benefit recipiency across states on the economic stabilizing effect of unemployment benefits. He compares the effect on stability of the 10 states with the highest recipiency rates to the 10 states with the lowest and finds that the high-low differential in stabilizing effects was 1.5 to 1. That is, states with high recipiency rates were 50 percent more effective than low recipiency states in stabilizing their economies through unemployment benefits.

Unemployment insurance eligibility and benefits vary widely across states

Federal laws and regulations provide broad guidelines to the states on their unemployment insurance systems in terms of who the program covers, who is eligible for benefits, and the level of benefits. Typically, eligibility is based on meeting earnings and hours thresholds over the year prior to losing a job involuntarily. There is wide variation across states in eligibility, which leads to large differences in how many workers in a state receive unemployment benefits (see Figure 1).

There are also wide differences in the level of benefits across states. Some of this is because of differences in local labor markets as states with lower median wages will have lower benefits. But, even beyond this, there is wide variation in benefits across states. Figure 2 shows a scatter plot of median wages and average weekly benefit amounts. While the relationship is upward sloping, the correlation between median wages and average weekly benefits is fairly small, indicating that there is wide variation that is not tied to local earnings.

The differences in eligibility criteria across state are one of the reasons for wide disparities in receipt of unemployment benefits by race and ethnicity. According to the Kirwan Institute, for example, among those unemployed, African Americans and Latinos are 25 percent less likely than whites to receive unemployment benefits. In 2009, African Americans were underrepresented among unemployment insurance recipients in 10 out of 21 states and Latinos were underrepresented relative to their share of the unemployed in 14 out of 18 states. The disparity is largely due to the disproportionate representation of workers of color among part-time, low-wage, and seasonal workers. These workers are much more likely to be ineligible for benefits and are less likely, even if eligible, to apply for benefits than high-wage and full-time workers.

In part to address these inequalities, the American Recovery and Reinvestment Act of 2009 included $7 billion in incentives for states to modernize eligibility by reducing restrictions. In order to receive the federal incentive dollars, states had to adopt an “alternative base period” that allows workers to include their recent earnings to qualify for unemployment benefits. Earnings from the current quarter—the calendar quarter that the worker filed for unemployment benefits—had often been excluded in earnings calculations when states make eligibility determinations. To receive additional federal funds, states must provide benefits to workers in at least two of the following four categories:

Part-time workers previously denied benefits because they were seeking part-time and not full-time work

Individuals who have had to leave work for compelling family reasons

Individuals with dependent family members who would qualify for $15 or more in weekly benefits per dependent to partially cover the costs associated with caring for that dependent

As of September 2010, 32 states had taken up the federal funding and modernized their unemployment insurance systems. The remaining 18 states have until August 2011 to enact reforms and receive the federal incentive monies.

The Extended Benefits program is a permanent program run by the states that is supposed to calibrate the weeks of benefits to labor-market conditions automatically by increasing the number of weeks of unemployment insurance benefits available to the long-term unemployed. It allows workers to receive up to 20 additional weeks of benefits after their original benefits expire, so long as they diligently look for a job but have no success, and their state has “triggered on” to the program. The program is supposed to trigger on when labor market conditions deteriorate and trigger off when they improve.

The Emergency Unemployment Compensation program is a fully federally funded program that Congress has implemented on an ad hoc basis. The most recent extension of EUC occurred on December 16, 2010, which extended unemployment benefits an additional 13 months until January 3, 2012.

Problem is, as currently structured, the EB program really doesn’t work. During the Great Recession, the share of funds being paid out through extended benefits has been very small relative to the EUC program. The basic problems are the triggers don’t work effectively and the funding scheme does not provide clear incentives to the states to use the program. Further, the EB program, as structured, provides insufficient tiers of extra weeks of unemployment benefits to deal with high unemployment recessions.

The triggers at which the EB program kicks in are set too high, which prevents many states from activating the program when unemployment begins to rise and states cycle off the program too early in the recovery because the triggers require ever-increasing unemployment rates in order to remain on. What’s more, the EB program ordinarily is funded 50-50 between states and the federal government, which creates an important incentive to not use the EB program, but wait for fully federally funded assistance through the congressionally-implemented EUC program. From the state’s perspective, this makes sense: The federal government has the ability to fund the extra benefits, but this means that the unemployed are then waiting on federal action. During the Great Recession, Congress has allowed benefits to lapse twice, leaving families in the lurch even as unemployment hovered above 12 percent in some states.

Congress dealt with states’ ambivalence about the EB program in the American Recovery and Reinvestment Act of 2009 by fully funding states’ EB programs if they adopted triggers that turned on quicker. But of the 38 states that provide EB, all but 11 states made the provision of EB dependent on full federal funding of the program. This means that when the most recent extension of EUC and the full federal funding of EB expire on January 4, 2012, so will the EB program in most states that provide it.

Finally, for the unemployment insurance system to be an effective automatic stabilizer, it must be adequately funded within a financing system that works. The system is designed to be a “forward-funded” system, meaning in good times there are more workers employed and tax revenues rise, with these revenues building up a trust fund to pay out benefits when unemployment rises. Most states, however, were not adequately forward funding their systems before the most recent recession, which, in any case, was deeper and more protracted than anyone had planned for.

At the end of 2007, before the Great Recession began, most states (33) had less than a year’s worth of reserves in their trust funds. The Great Recession lasted until July 2009, and in most states, the labor market is not yet recovered. As a result of a lack of adequate forward funding, most of the state unemployment insurance trust funds are insolvent and states have had no choice but to take out loans from the federal government. As of February 3, 2011, 31 states and the Virgin Islands had insolvent trust funds and owed $42.3 billion to the federal government (see Table 1). The U.S. Department of Labor estimates that by fiscal year 2013 the amount of outstanding loans could grow to over $65 billion. The loans balances are significant, ranging from around one percent to over six percent of state’s total budgets.

Under federal law, these funds must be paid back, often sooner than makes sense given economic conditions. There are two mechanisms at work. First, on November 10, 2010, three states saw a reduction in their state tax credit in the net FUTA calculation, which means that employers in those states saw an increase in net FUTA taxes (see Table 1). By 2012, the Department of Labor estimates that states will have to increase taxes on employers by nearly $2 billion.

Second, beginning October 1, 2011, states with loans have to begin paying the interest on their loans. Law also dictates that, while principal payments can be made with State Unemployment Tax Act tax revenue, interest payments cannot. States must make payments on interest through either general revenues or some other financing scheme. Texas, for example, has dealt with this problem by floating bonds to pay off their trust fund debt.

If history is any guide, the need to pay the loans on state trust funds will lead many states to act in ways that will aggravate, rather than ameliorate, the business cycle. A survey conducted by the National Association of Workforce Agencies found that state unemployment insurance taxes were expected to increase in 35 states for 2010 in order to address these trust fund solvency issues. States currently have little leeway to change benefits. The American Recovery and Reinvestment Act of 2009 had a “non-reduction” rule, which meant that any state that accepted the additional $25 in weekly unemployment benefits per employee in their state would not be able to reduce their benefit levels. This rule was reattached to the EUC program when it was extended in December 2010. Once the EUC program fades, which in many cases coincides with states paying off their loan principal, states will again be at liberty to make changes to their benefit levels.

It is all too likely that states with large loans will find it nearly impossible to pay down these loans, provide continuing benefits, a¬nd sufficiently capitalize their trust funds before the next rough patch hits. Most states will go into the next recession with even less reserves than what they had going into the Great Recession. Even if the economy moves to lower levels of unemployment by 2015 and the next period of high unemployment does not arrive for another five years, the structure of the unemployment insurance financing system makes it likely that state UI trust funds will still be undercapitalized. Doing nothing is not an option.

The proposal

Fixing the unemployment insurance system is neither easy nor simple. Our proposal aims to outline a broad framework to address the current challenges and lay the foundation for long-term stability and effectiveness of the system overall. As they say, however, the devil is in the details and along those lines we acknowledge that our proposal is a first step in a longer process of policy articulation. Furthermore, we propose that this plan be implemented in reasonable stages as the labor market recovers from the Great Recession.

In thinking through the options available, policymakers should keep the program’s goal of stabilizing and fueling the economy at the forefront of their thinking. Right now, we need to continue to spur economic demand and unemployment benefits remain our most potent tool to do that. Policy options should be evaluated with an eye to the long-term viability of the unemployment insurance system and should also ensure that until the unemployment rate comes back down, the system can effectively continue to serve as an automatic stabilizer, putting money in people’s pockets when they need it most. The criteria for inclusion in the proposal are:

Ensure that the system provides benefits with a reasonable wage replacement to those who have lost their jobs through no fault of their own and who continue to seek employment without success

Ensure that the system is flexible enough to extend the weeks of benefits as unemployment rises and job searches become longer

Ensure that the system is adequately funded within a financing system that works

We propose that the way to do this is to begin by clearing the slate of the debt currently on the books of states while rewarding states with positive balances. As a condition of benefitting from this clearing of the slate, we propose that policymakers clearly delineate and separate the federal and state roles in our nation’s unemployment insurance system moving forward by increasing the role of the federal trust fund during times of high unemployment and by improving the wide disparity in eligibility rules and benefits across states.

Clearly, on its own, forgiving these trust-fund loans would create moral hazard problems as states will get the message that if they do not forward fund their programs, the federal government will intervene during the downturns. This is why we put clear conditions on debt forgiveness that focus on improving the program’s core functions, while also rewarding the states that are not in arrears. Forgiving the loans without sufficient conditions is not an acceptable option as it would, among other things, make it much harder moving forward for states to convince the employers that forward funding their unemployment trust fund is a worthwhile endeavor.

The first condition for clearing the slate is that, moving forward, the states should be responsible for financing unemployment insurance benefits only when their state’s economy is not experiencing elevated and prolonged unemployment. States would trigger on to the program when their unemployment rate was elevated and the flow of funds into their system could not keep their trust fund solvent. To fund regular unemployment benefits during times when the unemployment rate is not elevated, states would continue to take in taxes under the State Unemployment Tax Act. Further, states would continue to administer their unemployment insurance programs and continue to have some, but not as much latitude in setting coverage, eligibility, and benefits.

A potential mechanism to ensure that states have the incentive to fund their portion of the program would be to link the state unemployment tax rate to the state’s trust fund reserve levels. That is, once a state trust fund’s reserves drop below a level sufficient to provide benefits at high rates for six months—an “average high cost multiple” of 0.5—the federal tax rate in that state would be automatically increased to maintain the trust fund. If trust fund reserves were above this level, incoming tax revenue would be diverted to the federal account. Thus, during periods of high unemployment, funds from this federal account would recapitalize state trust funds whose reserves had dropped below this requisite level. The power of this mechanism is that it builds adequate reserves during expansions, which could allow for automatic tax rate cuts during recessions, thus, adding an economic stimulus for firms and workers.

The federal government, through the already-established Federal Unemployment Tax Act of 1939, would finance unemployment benefits when unemployment was elevated and extra weeks of benefits for the long-term unemployed. Ideally, the federal government would broaden the federal base to match the Social Security wage base, which means policymakers can lower the tax rate currently in place for the Federal Unemployment Tax Act. This proposal would accentuate the insurance principals of the overall system because it would do more to spread the risk of high unemployment across the states and it would lower taxes for businesses with low-wage workers relative to the current status quo. It will also require rethinking how the federal government sets the base for the state unemployment taxes, which are currently aligned with the federal base.

The federal government already is playing a large role in the unemployment insurance system. Not only do the states owe more than $42 billion in loans, but since November 2009, most of the funds being distributed through the unemployment insurance system are federal dollars, not including the funds being loaned to the state systems to pay out regular benefits (see Figure 3). Since the federal government is now picking up the tab for benefits when the unemployment rate is high, the overall structure of the unemployment insurance system should incorporate this fact into the financing arrangements for the system.

The change in financing should be coupled with ensuring that the EB system is fully functional and that it is structured to respond to even deep recessions. There is already broad agreement that the automatic triggers in the EB system need to be fixed and President Obama’s fiscal year 2010 budget included $21 billion over 10 years to fix these triggers, but did not lay out a specific plan. The Center for American Progress has laid out a plan to fix the EB system, the basic elements of which are to turn the trigger for EB benefits on when a state’s unemployment rate rises to an average of 6.5 percent or more over a three-month period or when the number of people claiming unemployment insurance rises by 20 percent or more, with subsequent tiers of more weeks of benefits for the long-term unemployed that trigger on as labor market conditions worsen and trigger off as conditions improve. In our proposal, the “look back” period to turn the program off is fixed from the time the program triggered on.

The second condition is that in exchange for debt forgiveness and the federal government taking on the responsibility for benefits during periods of high unemployment, states would have to submit to greater harmonization of their eligibility and benefit levels. Our vision is that states would continue to have some discretion, just within a smaller band or a high floor or both, and that this would be a harmonization upwards, not downwards, especially with respect to eligibility criteria. Benefits should be set in terms of replacement rates, rather than levels, to be connected to local labor market conditions.

The high inequities in the unemployment insurance system across states cannot be maintained with federal dollars, nor do they promote the automatic stabilizer functions of the unemployment insurance system. Since one goal is to improve recipiency, this will have the added advantage of improving the overall automatic stabilizer function of the system.

Finally, it is essential that those states that provided adequate benefit levels and sufficiently forward-funded their unemployment insurance trust funds be rewarded for doing so. For this reason, we propose to allow those that have surpluses in their trust funds to keep the surplus funds for other uses. Policymakers will likely put some constraints on the use of these funds, but we leave that decision to a future iteration of this proposal. However, many of the solvent states voluntarily raised their SUTA taxes and put themselves at a competitive disadvantage to those states that chose to cut their own SUTA taxes and reduce benefits. For that reason, policymakers should strive to structure the plan to reward states that not only have solvent trust funds, but also meet certain benefits and eligibility requirements.

Who wins in this proposal?

We all benefit from an unemployment insurance system that can be an effective automatic stabilizer during recessions, especially prolonged recessions like the one we’re now escaping. We have seen how important this program has been during the Great Recession, not only alleviating hardships, but boosting the economy overall. From the federal perspective, a better-functioning unemployment insurance system will be a much-improved tool for macroeconomic stability.

States also benefit from this proposal as the ongoing difficulty of financing their unemployment insurance trust funds for recessionary periods is eliminated and the burdensome cost of making interest and principal payments on the trust fund loans is eliminated. Those states that have been solvent will see an immediate increase in funds available for other purposes, as trust fund surpluses can be reallocated to other purposes.

Employers will not have to bear potentially escalating tax increases to pay for loans to the federal government. While our proposal calls for an increase in the amount of wages subject to federal unemployment taxes under the Federal Unemployment Tax Act, it should still save employers money compared to what would happen if our proposal were not implemented as they will not have to pay back extremely onerous current debts.

By providing a more stable financing system for unemployment insurance, employees can be assured that their benefits will be available at times of crisis. This will benefit not only those that experience unemployment but will help boost the economy overall and dampen the depth of future recessions for everyone.